Restraining Government in America and Around the World

Weekly Economics Lesson: The Problem Is Spending, not Deficits

The Wall Street Journal has a column identifying fiscal deficits as the greatest threat to European economic performance. As this passage indicates, many European nations have enormous deficits and debt, much larger than the United States:

Excessive euro-zone deficits now present one of the biggest risks to the global recovery. Several European countries – Greece, Italy and Belgium – already have debts of more than 100% of gross domestic product. Others will join them in 2010. Across the euro zone, the deficit in 2010 is likely to be more than 7% of GDP. …The snag is that no one knows how far or how fast countries must cut their deficits to retain the support of markets. Government bonds are being artificially supported by central-bank policies. …Greece and Ireland’s bonds already yield close to 5%, around 1.7 percentage points more than Germany’s. …If yields rise too high, deficits will become unsustainable. Medium-term, most countries need strong growth to reduce debt before they are hit by the huge demands on social spending as the baby-boomer generation retires. In theory, rising yields should impose market discipline on wayward governments. But without the traditional safety valve of devaluation, the sacrifices needed to restore competitiveness via wage deflation and falling living standards may be too much to expect from elected politicians. …The market assumes that if one member state faced a buyers’ strike, the others would ride to the rescue, despite the euro zone’s no-bailout policy.

The column identifies some key concerns, but are budget deficits really the problem? Would these European nations be better off, for instance, if they imposed massive tax increases? Setting aside Laffer Curve concerns, big tax hikes could close the fiscal gap. Is it reasonable, then, to think that Europe’s economies would respond with more growth? That is highly unlikely. Replacing debt-financed spending with tax-financed spending merely changes the mechanism for diverting resources from the productive sector of the economy to the government. Yes, deficits and debt undermine economic performance by draining resources from private credit markets. But higher tax rates also stifle growth by decreasing incentives to work, save, and invest.

The real problem is that government is far too big in Europe. This is the crisis, and it is a problem that America is now facing as a result of the profligate Bush-Obama policies.